What Business Sellers Need to Know About Due Diligence

It’s common sense to do a little background research before any important purchase — whether that means checking reviews for a new dishwasher, having a mechanic inspect a used car or browsing forums before choosing a contractor.

In the M&A world, as buyers and sellers negotiate high-value business transactions, due diligence becomes a longer and more complex process. With so many stakeholders involved — not just the principals of the deal, but lenders and outside investors as well — it’s vital to examine the details thoroughly so that all parties can move forward with confidence.

If you’re selling your business and have never been through due diligence before, here’s what to expect from the process.

Early due diligence

The first thing to understand about due diligence is that it’s not a quick, one-time task; it’s an ongoing process that unfolds as a deal progresses. Over several months, the principals in an M&A transaction face a series of increasingly detailed questions digging into their companies’ financial health, legal standing and potential liabilities. Some of these issues are addressed early on, before business terms are finalized, and then affirmed in the letter of intent.

At first, counterparties need only enough high-level information about each other to justify further discussions about a potential deal. Once those conversations begin in earnest, the next stage of due diligence focuses on evaluating the deal’s likelihood of success. This might include analyzing financial trends, assessing the market or customer need supporting the deal, and identifying potential operational risks that could impact its success.

Next, both sides need to gather enough details to clearly describe the financial parameters of the deal. At this point, they’re taking the other party’s word that all the information provided is accurate, but that will soon change.

After the letter of intent

Signing a letter of intent opens the door to a more involved phase of due diligence, called confirmatory due diligence. The parties must provide verifiable facts to confirm that the terms they’ve tentatively agreed upon are firmly grounded in reality. Altogether, the parties may be required to answer hundreds of questions as part of this process.

Due to the complexity and detail involved in due diligence, it’s common to assemble a core team of experts covering various legal, financial and operational areas. These three specialties are always included:

1. An accountant: Reviews financial statements and tax records to ensure accounting principles are correctly and accurately applied.
2. A lawyer: Specializes in legal and compliance issues, reviewing contracts and key documents, such as client lists, to verify compliance with relevant laws.
3. An investment banker or broker: Acts as a deal manager and evaluates the fairness of the business terms.

Other specialists can assist as needed. For example, if a deal involves property and the current owners claim the land has no environmental issues, an environmental expert may be brought in to verify that claim through thorough assessments and site inspections.

Due diligence strategy

It should go without saying that due diligence requires both parties to be completely honest with one another. But it’s not helpful for one party to overwhelm the other with information that they might not want or need.

To maintain rigor while staying organized, we recommend that buyers and sellers follow a process based on a defined, recognized list of questions. Not every question will apply to every situation, and sometimes one party may feel the other is digging too deeply. However, if both sides approach the process with patience and mutual respect — understanding that the goal is to provide stakeholders with the assurance they need to proceed confidently — then the process can be constructive and smooth.

When unfavorable details must be shared with the other party, context is essential. Be fully transparent, framing the information as part of your overall business story and include any supporting evidence that helps explain and validate the facts.

The value of investment bankers

Selling a business is often a stressful and emotional journey, made more challenging by the thoroughness of due diligence. However, enduring this process is far better than entering a business arrangement with a company that has not been fully transparent or has misrepresented itself.

An experienced investment banker or consultant can significantly ease this burden. Not only do they understand the key questions buyers and sellers want answered, they can also act as a project manager — bringing in experts when needed, foreseeing common obstacles, guiding negotiations and moving the process forward. Their support can help business owners navigate the stress of selling while focusing on achieving the best possible outcome.

My firm is an investment banking firm, but I wrote this piece for you, fellow members of Collective 54, not to push what we do specifically. Rather, it seemed worthwhile to explain what the industry we’re part of does to help in situations that are relatively rare for most firm owners. At the time of a business sale or acquisition, take the time to interview investment bankers – probably a professional you haven’t worked with before — and find one that you feel will guide you effectively on this journey.